Ch. 16 - Capital Structure Decisions: The Basics

Two new dimensions of risk

1. Business risk is the risk of the firm's stock if it uses no debt 2. Financial risk is the additional risk placed on the common stockholders as a result of the firm's decisions to use debt THe greater the use of debt, the greater the concentration of risk on the stockholders, and the higher the cost of common equity.

Business Risk depends on

1. Demand variability 2. Sales price variability 3. Input cost variability 4. Ability to adjust output prices for change in input costs. The greater the ability to adjust output prices to reflect cost conditions, the lower the business risk. 5. Ability to develop new products in a timely, cost-effective manner. 6. Foreign risk exposure. 7. The extent to which costs are fixed: operating leverage. If a high percentage of its costs are fixed, hence do not decline when demand falls, then the firm is exposed to a relatively high degree of business risk.

Estimating the Optimal Capital Structure

1. Estimate the interest rate the firm will pay 2. Estimate the cost of equity 3. Estimate the weighted average cost of capital 4. Estimate the free cash flows and their present value, which is the value of the firm 4. Deduct the value of the debt to find shareholders' wealth, which we want to maximize.

Bankruptcy-related costs have two components

1. The probability of financial distress and 2. The costs that would be incurred given that financial distress occurs. Firms with high operating leverage, and thus greater business risk, should limit their use of financial leverage.

MM assumptions

1. There are no brokerage costs. 2. There are no taxes. 3. There are no bankruptcy costs. 4. Investors can borrow at the same rate as corporations. 5. All investors have the same information as management about the firm's future investment opportunities. 6. EBIT is not affected by the use of debt. It does not matter how a firm finances its operations, so capital structure decisions would be irrelevant.

Pecking order

A firm first raises capital internally by reinvesting its new income and selling off its short-term marketable securities. When that supply of funds has been exhausted, the firm will issue debt and perhaps preferred stock. Only as a last resort will the firm issue common stock.

Capital Structure decision

A firm's choice of a target capital structure, the average maturity of its debt, and the specific types of financing it decides to use at a particular time. THe only way any decision can change a firm's value is by affecting either free cash flows or the cost of capital.

Operating Leverage

A high degree, other factors held constant, implies that a relatively small change in sales results results in large changes in EBIT. The higher a firm's fixed costs, the greater its operating leverage. The higher a firm's operating leverage, the higher its business risk. To a large extent, operating leverage is determined by technology.

Estimating the cost of equity

A stock's beta is the relevant measure of risk for diversified investors. The beta increases with financial leverage.

Estimating Shareholder Wealth and Stock Price

After issuing the debt but before repurchases stock, the firm will temporarily put the cash proceeds from the debt issue into short-term investments until it is able to complete the repurchase. 1. Decreases the WACC 2. Increases the value of operations 3. Increases shareholder wealth, and 4. Increase the stock price

Bankruptcy Risk Reduces Free Cash Flow

As the risk of bankruptcy increases, some customers may choose to buy from another company, which hurts sales.

Optimal Capital Structure

Can add 10% to 20% more value relative to zero debt, and there is a fairly wide region over which value changes very little. For some companies there is a capital structure that maximizes EPS, but this is generally not the same capital structure that maximizes stock price. This is one reason we focus on cash flows and value rather than earnings.

Reserve borrowing capacity

Firms should, in normal times, use more equity and less debt than is suggested by the tax benefit/bankruptcy cost trade-off model.

Consistent with the windows of opportunity

Firms tend to issue short-term debt if the term structure is upward sloping but long-term debt if the term structure is flat. Investment opportunities influence attempts to maintain reserve borrowing capacity.

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Firms with many profitable opportunities should maintain their ability to invest by using low levels of debt, which is also consistent with maintaining reserve borrowing capacity. Firms with few profitable investment opportunities should use high levels of debt and thus substantial interest payments, which means imposing managerial constrain through debt.

The net effect on the weighted average cost of capital

If we increase the proportion of debt, then the weight of low-cost debt increases and the weight of high-cost equity decreases. If all else remained the same, then the WACC would fall and the value of the firm would increase.

Financing with debt

Increases the common stockholders' expected rate of return for an investment, but debt also increases the common stockholders' risk. This holds with financial leverage.

Leveraged buyout

Is one way to bond cash flow. Debt is used to finance the purchase of a company's shares, after which the firm "goes private."

Informational asymmetry

Managers are in a better position to forecast a company's free cash flow than are investors. Investors perceive an equity issue as a negative signal, and this usually causes the stock price to fall.

Windows of opportunity

Managers issues equity when they believe the stock market prices are abnormally high and issue debt when they believe interest rates are abnormally low. Differs from signaling theory because no asymmetric information is involved: These managers aren't basing their beliefs on insider information, just on a difference of opinion with the market consensus.

Miller: The Effect of Corporate and Personal Taxes

On average, returns on stocks are taxed at lower effective rates than returns on debt. Therefore, investors are willing to accept relatively low before-tax returns on stock relative to the before-tax returns on bonds. 1. The deductibility of interest favors the use of debt financing 2. The more favorable tax treatment of income from stock lowers the required rate of return on stock and thus favors the use of equity financings The presence of personal taxes reduces but does not completely eliminate the advantage of debt financing.

Signaling Theory

One would expect a firm with very positive prospects to try to avoid selling stock and, rather, to raise any required new capital by other means, including using debt beyond the normal target capital structure. A firm with negative prospects would want to sell stock, which would mean bringing in new investors to share the losses.

Hamada equation

Shows how increases in the market value debt/equity ratio increases beta. The firm's unlevered beta is the beta it would have if it had no debt. Therefore, beta would depend entirely on business risk and thus be a measure of the firm's "basic business risk." Beta is the only variable that can be influenced by management in the CAPM equation.

Bankruptcy Risk Affects Agency Costs

Since most stockholders are well diversified, they can afford for a manager to take risk on risky but positive NPV projects. But a manager's reputation and wealth are generally tied to a single company, so the project may be unacceptably risky from the manager's point of view. This called underinvestment problem.

Financial risk

The additional risk placed on the common stockholders as a result of the decision to finance with debt. The use of debt, or financial leverage, concentrates the firm's business risk on the stockholders. This concentration of business risk occurs because debtholders, who receive fixed interest payments, bear non of the business risk.

Debt Increases the cost of stock

The fixed claim of the debtholders causes the residual claim of the stockholders to becomes less certain, and this increases the cost of stock.

Estimating the WACC

The increasing costs of the two components offset the fact that more debt (which is still less costly than equity) is being used.

Debt reduces the taxes a company pays

The reduction in taxes reduces the after-tax cost of debt.

Business Risk

The risk a firm's common stockholders would face if the firm had no debt. Business risk arises from uncertainty in projections of the firm;s cash flows, which in turn means uncertainty about its operating profit and its capital (investment) requirements. The return on invested capital (ROIC) combines these two sources of uncertainty, and its variability can be used to measure business risk on a stand-alone basis.

Repurchases Stock

The stock price remains the same after the repurchase of stock. The short-term investments are sold and the cash is used to repurchase stock. The firm is left with no short-term investments. The repurchase doesn't affect the amount of debt, so the firm's value of equity is equal to its total value minus the debt. After the repurchase, shareholders directly own the funds used in the repurchase; before the repurchase, shareholders indirectly own funds.

MM The Effect of Corporate Taxes

The tax deductibility of the interest payments shields the firm's pre-tax income. The value of a levered firm is the value of an otherwise identical unlevered firm plus the value of any "side effects." Optimal capital structure is virtually 100% debt. Under MM with corporate taxes the WACC falls as debt is added.

Implication for Managers

The time value of money means that tax benefits are more valuable for firms with stable, positive pre-tax income. A firm with less operating leverage is better able to employ financial leverage because it will have less business risk and less volatile earnings.

Trade-off Theory

The value of a levered firm is equal to the value of an unlevered firm plus the value of any side effects, which include the tax shield and expected costs due to financial distress.

The risk of bankruptcy increases the cost of debt

With higher bankruptcy risk, debtholders will insist on a higher promised return, which increases the pre-tax cost of debt.